Emerging-market stock funds have offered rewards, risk

Andrew Leckey

Investors nervous about the U.S. economy are casting their eyes overseas.

Emerging markets especially capture their attention. These carry higher risk, but returns have been dramatic.

Emerging-markets stock funds turned in an average gain of 36 percent last year, according to Lipper Inc., with a three-year annualized return of 33 percent. China, the Pacific (excluding Japan) and Latin America were stellar regions in a year that rewarded the daring.

Some experts expect the momentum to continue, though it will be tough to match the recent years' results.

"We're going to maintain a heavier weighting than usual in the emerging markets in 2008, with a 22 to 27 percent exposure in them," said Lynette Schroeder, lead manager for $855 million Driehaus International Discovery Fund, which includes developed and emerging foreign markets. "The primary drivers for emerging markets have been commodities, domestic demand and overall growth in their economies."

Driehaus International Discovery gained 29 percent in 2007 and has a three-year annualized return of 30 percent.

"The really big question is whether domestic growth in countries such as China will be able to offset any slowdown the U.S. sees, and we don't know the answer to that yet," said Schroeder, who said her volatile fund should represent the riskier portion of an individual's portfolio.

Nearly half of Driehaus International Discovery's holdings are in the United Kingdom and Western Europe, with another one-fourth in Asia, excluding Japan. The remainder is mostly in North America, Japan and Latin America. Even though developed markets move more slowly, Schroeder is able to find companies within them that feature strong earnings growth.

"We advise investors to consider dollar-cost averaging for their international investing in 2008," Schroeder said. "For example, they could put $2,000 into our fund in January and wait until mid-February to put in more, since I think markets are going to be volatile, and you'll get a better overall return that way."

The move to emerging markets would have been more rewarding if you had acted sooner.

"We still see a lot of momentum in emerging markets and think it will continue to outperform in 2008," said Alec Young, international equity strategist with Standard & Poor's Corp. in New York. "Although we think gains will moderate to the 10 to 15 percent range this year, that will still be enough to outperform the U.S. and other developed markets."

A good low-cost way to invest in emerging markets is an exchange-traded fund, such as the $25 billion Vanguard Emerging Markets Stock Fund, Young said. Mimicking performance of the Morgan Stanley Capital International Emerging Markets index, it had a one-year return of 34 percent and has a low annual expense ratio of 0.30 percent.

ETFs trade on exchanges like stocks.

That ETF's greatest concentration is in Asia, excluding Japan, representing more than half of holdings. Latin America is about one-fifth of portfolio, and the rest is scattered around the world. Largest holdings are Russia's Gazprom OAO in energy; Hong Kong's China Mobile Ltd. and Mexico's American Movil S.A.B. de C.V. in telecommunications; South Korea's Samsung Electronics; and Brazil'sCompanhia Vale do Rio Doce in industrial materials.

"While very few active managers can beat the benchmark indexes over time, you can do some research to find the handful of really great active international managers," Young said. "A good example is Mark Mobius of Templeton Developing Markets Fund."

The $6 billion Templeton Developing Markets Fund "A" was up 26 percent in 2007 and has a three-year annualized return of 28 percent. That strict value fund has been run since 1991 by lead manager J. Mark Mobius, a legend in emerging-markets research and investment for decades.

Hong Kong's Aluminum Corporation of China Ltd. and PetroChina are among the top holdings, along with Turkey's Akbank T.A.S. and China Petroleum & Chemical. The fund requires a 5.75 percent load and $1,000 minimum initial investment. The annual expense ratio is 1.86 percent.

"The big message is that Americans don't have enough international exposure, and, within that, they don't have enough emerging markets," Young said. "They need that exposure for the long-term good of their retirement goals."

The other side of the argument is that no rewards come without assuming risk. Politics, economies and currencies play significant roles in a variety of emerging countries. After all, the world outside the U.S. isn't one big, happy economic playground.

"The kinds of returns that international funds have posted in recent years, especially in emerging markets, are simply not sustainable," said William Rocco, senior analyst with Morningstar Inc. in Chicago. "If you think that the three-year annualized returns over the next three years will be as good as the last three, you are likely to be disappointed."

The message for 2008 is to move some money outside U.S. borders to capture better performance but invest it judiciously.